Risk-Arbs Make A Killing Off Proposed Tesla-SolarCity Merger

Wall Street is full of surprises. Perhaps there was no bigger surprise than when Tesla Motors Inc TSLA announced its intentions to purchase SolarCity Corp SCTY after the close on Tuesday.

Although both companies are the brainchild of the prodigy Elon Musk, the synergies of the deal are lacking in one key area: shoring up the limited production of Tesla cars.

That aside, how does one account for the mysterious price action in the shares of both companies which took place off the open? Very simple: the smart and big money in the risk-arbitrage arena made a calculated bet on the possibility of the deal actually coming to fruition.

Based on the discount afforded to several other deals as of late, the Street has factored in substantial discounts to the deals being completed. In some cash deals, with limited hurdles to clear, the Street will still factor in a small discount.

In other deals, with regulatory worries and other hurdles to clear, the Street will factor in anywhere from a 5 to 20 percent discount. In other words, attempting to limit their losses if in fact the deal is nixed.

Related Link: Jim Chanos Thinks Tesla-SolarCity Deal Is 'Shameful'

Off the hop in after-hours trading, the risk arbs were not immediately present to accurately price probability of the deal being completed. As a result, SolarCity spiked to just shy of the midrange of the proposed deal to $27.23.

The proposed price was derived from the proposed ratio of 0.122 to 0.131 per share of Tesla. Using the midrange of the proposed ratio (0.126) coupled with Tesla's closing price on Tuesday ($219.61) equates to $27.67 which was just above the after-hours high.

Buyers of Solar City anywhere near that price were ignoring two very important factors that would severely hamper any upside potential. First of all, had they been paying any attention to the price of Tesla shares (that went into a freefall), they would have to factor in the impact of what a lower Tesla price would have on the corresponding price of SolarCity shares based on the proposed. ratio. In reality, SolarCity will not be worth $27.67, until Tesla gets back to Tuesday's closing price.

More importantly, buyers at those elevated prices were totally ignoring any kind of a discount that the risk-arbs would put on the deal. Based on recent discounts, it could be hefty. Besides regulatory hurdles to clear, the deal must be approved by Tesla shareholders, who at the moment may not be too pleased with Musk's slick maneuver.

Keep in mind, many new shareholders are jammed at $215, which was the price of a secondary offering last month, How many of these new shareholders would have said "no thank you," knowing beforehand what Mr. Musk had planned to do with at least a portion of the new cash.

So what happened off the opening bell in both of these issues? The risk-arbs went to work big time, knowing full well there was no clear and easy path for the deal to close.
Depending on their appetites for risk, the arbs had pre-determined ratios they would aggressively purchase Tesla shares and short the same dollar amount of SolarCity. To illustrate the profit potential in this strategy, just take a gander at the following table.

Any trader buying TSLA and shorting SCTY Tuesday night (in equal dollar amounts) could have made a quick 13-15 percent in one day!

Even traders who didn't trade last night could have still made some nice money this morning. Using the opening prints from today as an example and done in equal dollar amounts, the numbers speak for themselves. Any trader who went long TSLA at the opening print of $199.47, and sold SCTY short at the opening print of $23.80 would have lost 1.4 percent on TSLA. But they would have made 8.1 percent on SCTY!

The downside to this strategy is two-fold. The first one being: another company comes in to purchase Solar City at a price that is substantially higher than Tesla's proposed price. However, that seems unlikely at this time. Also, if the deal is truly executed at the stated parameters and the markets adjust to reflect the current ratio.

On a final note, investors contemplating this type of strategy in these issues or any other future deals, should keep in mind that is called risk-arbitrage for a reason - the "risk" part of the name. In the wacky world of Wall Street, even the best-laid strategies can lead to ruin.